Entrepreneurial Finance: Banks versus Venture Capital

Abstract

We analyze how entrepreneurial firms choose between two funding institutions: banks, who monitor less intensively and face liquidity demands from their own investors, and venture capitalists, who can monitor more intensively but face a higher cost of capital due to the liquidity constraints that they impose on their own investors. Because the firm's manager prefers continuing the firm over liquidating it, and aggressive continuation strategies over conservative strategies, the institution must monitor the firm and exercise some control over its decisions. Bank finance takes the form of debt, whereas venture capital finance often resembles convertible debt. Venture capital finance is optimal only when (1) the aggressive continuation strategy is not too profitable, ex-ante; (2) the firm faces high uncertainty in its choice of continuation strategy; and (3) the firm's cash flow distribution is highly risky and positively skewed, with low probability of success, low liquidation value, and high returns if successful. A decrease in venture capitalists' cost of capital encourages firms to switch from safe strategies and bank finance to riskier strategies and venture capital finance, increasing the average risk of firms in the economy.